Home Depot (HD)
Though not quite as economically sensitive as a company operating in, for example, the automotive industry, investors who purchased Home Depot shares in the midst of the housing bubble are up only marginally on their investment, not including dividends. Since the bubble burst, Home Depot has been investing heavily in its core businesses (at excellent rates of return - about 13%), and buying back shares at prices I believe to be well below their price to value ratio.
Management is aiming for 15% return on invested capital. This is excellent - I'd be happy to attain 15% returns on my own investments. Returns on equity have been very solid, coming in at 20%. Management's approach to leverage seems fairly careful; the total debt would take only a couple years to pay off with generated cash flows. Additionally, the company has $2.23 billion in cash and cash equivalents.
Management, led by CEO Francis Blake, seems to be very shareholder-oriented. Their philosophy is to deploy necessary capital back into the business, and return the leftovers to shareholders via share repurchases or cash dividends. The company has bought over 9 million shares under the current program, and wants to purchase $6.8 billion worth of shares by 2014 - 151 million shares at current prices. In terms of dividends, though, investors have only seen two consecutive annual increases. There hasn't been a dividend cut in decades, and payouts appear to be increasing, as outstanding shares are reduced and cash flow generation increases. The company bumped its fourth quarter dividend 16% to $.29 per share, and raised its payout target (based on EPS) to 50% from 40%. The current payout ratio is 42%, so earnings growth, in conjunction with a higher ratio, should provide incremental increases yield going forward.
The first segment of HD's business is the "Do-it-Yourself" business. This simply describes a customer coming into the store, purchasing his or her desired products, and completing their project themselves. The second segment, "Do-it-for-me," involves a customer both purchasing the required materials and labor for the job, directly from a Home Depot store. Lastly, the company caters to professionals, where they generate revenues via deliveries and will-call services, in addition to credit programs.
The company earned $1.34 per share in 2008, $1.57 in 2009, $2.01 in 2010, and should earn about $2.38 in 2011, an annual increase almost 20%. This kind of earnings growth during in increasingly weak housing market tells us a few things:
- Management has adequately reduced its cost structure to improve profits
- Share buybacks have greatly increased the earnings power of a piece of ownership in the firm
- Households are at least doing some investment in their homes
I am very bearish on the medium-term housing market. Americans have not saved meaningful portions of their incomes for a decade, while incomes have been relatively stagnant. While consumer leverage reached epic proportions (and is starting to take off once again). With stricter lending standards, few Americans can draw enough from their savings to put, say, 30% down on a home. In addition, by capping the price (interest rate) of money, the Fed has induced a shortage of credit, or willingness to lend. This, in economic terms, is a price ceiling. We are seeing the effects of this, as banks sit on more than a trillion of excess reserves. While the supply/demand equation will eventually work itself out as our population grows (the key difference between the U.S. and Japan), housing growth is likely to remain pretty muted over the next 5-10 years.
Despite all of this, Home Depot is capable of taking more industry market share, and is also ready to take advantage of new growth opportunities. One area of potential growth is online sales. HD recently acquired Redbeacon for an undisclosed sum. Redbeacon is a highly touted service where users can search and book home service providers, such as plumbers, electricians and maids. Redbeacon receives fees from the actual service providers when they are hired. Admittedly, I can't say with certainty that this is the way consumers are going to be booking their home services in ten years, but it certainly appears that flipping through a phonebook to find a plumber is on its way out. By using some personal information about its users, Redbeacon can provide excellent matches. This should be a growing trend over the next decade, and Home Depot's purchase is quite intriguing.
The company also wants to grow its own website sales. HD said that 45% of the 9.5 million customers who went to Home Depot's website ended up taking a trip to a Home Depot store. This led to 225 more customers per store.
As for valuation, I highly recommend that prospective investors wait for a better price here. The company is trading at 14 times free cash flow, and 19.5 times earnings, with a current yield of 2.60%. A pullback into the upper 30s will start you off with a yield of 3.0%, an earnings multiple closer to 16.5, and an FCF to price ratio of 12. The market seems to be pricing in a quick turnaround in housing, and a possible round of mortgage backed security purchases. Granted, over the remaining life of the business, buying at a slightly lower price won't make all the difference in the world if I'm right about its prospects and potential for yield growth, but a bigger (margin of) safety net never hurts. It doesn't hurt to wait a bit to buy a great business at good price.
Unilver fits nicely into any portfolio, but fits a dividend growth portfolio as well if not better than most stocks I've been able to find throughout my research.
The first thing that stuck out to me is Unilever's incredibly recognizable brand names. Building brands is imperative in almost all businesses, and supreme brand strength should be looked at as an ultra-valuable asset which requires far fewer capital investments than a tangible asset often does. Additionally, it's quite difficult to take market share away from established brands. The psychological impact of a brand is far more powerful than the actual product, and this creates a demand schedule which is relatively more inelastic in normal economic times.
Some of UL's key brands:
- St. Ives
These brands, among others, fit into home care, personal care and food.
Earnings growth has been consistent over the past decade, and the company has managed annualized EPS growth of more than 15% since 2001. The company earned 1.41 euros per share, or roughly $1.87 per share in fiscal 2011. The company saw 6.5% underlying sales growth, driven mostly by increased pricing power (which had been a worry, given retail sector consolidation). Profit and operating margins have improved steadily since 2001, displaying strong economies of scale.
Over the last five years, UL has achieved average returns on equity of over 35%, return on invested capital of 23.5%, and gross profit margins of 37%. This is the type of business I'd like to be in for the next couple of decades; fantastic returns on deployed capital and well above average returns on equity are always comforting.
Unilever does a good deal of its business in emerging markets, like Africa and Asia, in addition to the entire European continent and the Americas. This kind of global diversification is important to have in at least some of your holdings, as it tends to dampen earnings volatility and simply prevents overexposure.
Currently, UL pays a 3.70% dividend, which has grown at an annualized pace of 15% over the past five years. UL is a "dividend contender," with 11 consecutive years of dividend increases. An initial yield as high as 3.70%, in conjunction with steady earnings growth, will provide long-term investors with excellent rates of dividend compounding. This results in an exceptional yield on cost in only a few short years.
UL trades at 17 times trailing earnings, and at about 16 times free cash flow. While I'd like to see valuations come down a bit across most dividend payers, the economics of the business and strong yield make UL a strong long-term buy at current prices.
Five More to Consider
Union Pacific (UNP) - 6 straight years of dividend increases, including a 26% bump from last year's payout. Current yield is 2.10%. 32,000 miles of track means some serious productive land value which is not being carried on the books. Links the Pacific Coast to the Gulf Coast; there has been a definite demographic shift to the West over the past decade. Strong returns on invested capital and equity.
Microsoft (MSFT) - 7 years of consecutive increases, along with a recent 25% increase. Current yield is 2.60%. Windows and Microsoft Office are huge, ultra-high margin businesses, but their markets are drying up. MSFT's future success depends on product innovation from within. They were late to the smartphone party, which hurt pretty bad. Microsoft has had an embarrassment of poor products over the years, like the Zune and their first few tries at smartphone operating systems. This has resulted in a compressed P/E ratio all the way down to 11, despite almost $4 per share in net cash. Regardless, returns on equity (40%) and ROIC (over 35%) have been phenomenal, and imply that MSFT is still efficiently allocating capital (granted, we already know that MSFT's traditional businesses produce excellent ROC). If you believe to have superior insights on MSFT's business, invest away. The cash flow generation is exceptional, and the payout will rapidly increase over the next decade.
Altria (MO) - Altria is certainly a dividend king, with 43 years of increases and a 5.70% yield even at an inflated valuation. Smoking isn't going away, and solid product innovation and brand recognition will aid MO in producing underlying earnings growth over the next few decades, but I expect the share price to lag considerably unless prices go down. Zero interest rate environments like this one cause classic dividend stocks to enjoy a premium relative to normal interest rate periods. Don't buy this one yet; wait for a normalized interest rate environment. Yes, that could be years, but you won't miss anything in terms of price appreciation, just a couple years of dividend compounding at inflated prices.
Clorox (CLX) - Carl Icahn's activity pumped a premium into the price, but that appears to have worn off. The company pays a 3.50% dividend, at a 56% payout ratio. With 34 straight dividend increases and a recent 9% increase, long-term dividend returns are set to be excellent. The economics of the business are very solid, with strong household brands.
Intel (INTC) - Though Buffett is not likely to have been the brains behind Berkshire's new stake in Intel, the purchase is worth looking into. Investors (including myself) would have been wise to initiate a position when the stock dropped below $20 during the summer mini-crash. At that point, the yield was over 4%, and the stock was cheap by every trailing multiple out there. 2012 was a gigantic year for the company, as massive share buybacks (at favorable prices) and organic growth, particularly in Asia, drove earnings to record levels. Going forward, the company needs to heavily penetrate the smartphone market. Their chips have been shunned by most smartphone producers as they take up too much energy, but Intel appears to be on its way after some heavy R&D spending. The nature of Intel's business is a bit harder to predict, but the company is shareholder friendly and has strong brand names in the PC and server businesses, as well as with their new acquisition, security giant McAfee. While Intel looks exceptionally cheap on a 12 month trailing basis, six year annualized earnings have the company trading at closer to 20 times earnings. Granted, growth and market share in their Asian segment has exploded, but you may want to wait for a pullback to enhance your margin of safety.